Special Report on Consumer Spending

Is the consumer growth engine
running out of steam?

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The EY ITEM Club Special report takes a detailed look at the factors likely to drive consumer spending growth from 2017-20. The report looks at factors such as inflation, wage growth and welfare payments to gauge how consumers’ spending power is likely to change. It also considers the importance of non-income factors, such as developments in household wealth. How these trends will impact upon different income groups is also assessed.

 

The end is in sight...surely?

by Mark Gregory,
EY Chief Economist, UK and Ireland

For some time now, I have been expecting consumer spending growth to slow down. Headwinds have been strengthening, inflation has been ticking upwards, and changes in the external environment should have dented consumer confidence. However, as the latest EY ITEM Club Special report on consumer spending shows, consumers have continued to forge ahead – increasing their spending by 3.1% in 2016, the highest rate for 12 years.

But despite a strong 2016, the end of the consumer push is now in sight. The EY ITEM Club expects rising inflation to depress households’ spending power, particularly when combined with the continued weakness of pay growth, the declining scope for further employment gains, and welfare cuts. While there may be some support from the strength of household finances, growth in dividend income, and the prospect of tax cuts, these will mainly benefit richer households. So a consumer slowdown is coming – and it will probably be borne disproportionately by the less well-off.

As the pressure on real incomes grows…

Against this background, the main drivers of the EY ITEM Club’s forecast for consumer spending are:

  • CPI inflation of 2.8% in 2017;
  • Modest acceleration in earnings growth from 2.4% in 2016 to 2.9% in 2017, not enough to offset the rise in inflation;
  • Employment virtually stagnating in 2017 and the Labour Force Survey (LFS) unemployment rate rising to almost 5.5% by the beginning of 2018;
  • Challenging conditions for non-wage income, as 11.5 million UK households continue to be affected by the cash freeze on many working-age benefits.

Overall, real household disposable income is projected to drop by 0.3% this year, the first decline since 2013, with a rise of just 0.2% expected in 2018. As inflation starts to slow down again, spending power will recover. However, the forecast average real income growth of just 0.8% a year from 2018-20 will be less than half the rate seen in 2014-16.

…the impacts will vary by income level…

Turning to the outlook for different household groups, the pressure on incomes and spending is set to be firmly regressive in the near future – meaning it will hit poorer households harder. Alongside real-terms cuts in working-age benefits, those at the lower end of income distribution will also suffer relatively more from price increases for essentials like fuel and food. And gains from future income tax cuts will go primarily to better-off households, as will those from further increases in the National Living Wage. Meanwhile, the continuation of the pensions “triple-lock” means pensioners will continue to gain relative to working-age households.

…creating a “perfect storm” for businesses…

Slowing consumer spending creates challenges for businesses at any time, but this slowdown is coming at a particularly difficult moment. Rising inflation will not just impact real income growth, but also increases the costs of doing business as inputs and resources become more expensive. With policies such as the Apprenticeship Levy and pensions auto-enrolment to deal with in an environment of uncertainty, businesses need a clear strategy.

…that requires a clear response

Businesses should, as a matter of urgency:

  • Review their pricing, and consider what share of increased costs they can pass on. They should also drill down to understand the potential impacts of the changes on different market segments: for example, it may make sense to focus more effort on selling to higher-end consumers and pensioners. Equally, getting in ahead of competitors to introduce cheaper offers at the lower end of the income scale could win market share.
  • Assess the potential impact of changes in the economy on the workforce. Firstly, think about the labour supply and how this may change if welfare reforms reduce the incentives for some groups to work, while immigration policies in the run-up to Brexit could disrupt the supply of non-UK labour. These potential shifts in the availability of labour could boost demand for some skill sets, bringing implications for wage levels. Whatever happens, understanding future labour market dynamics is critical.
  • Analyse the scope to drive productivity improvements – whether through investing in labour-saving technology, or making changes to supply chains. If imports are becoming more expensive due to the change in the value of sterling, now is the time to start sourcing more inputs locally. This might provide further insurance against the risk that the UK fails to agree a post-Brexit trade deal with the EU.

Overall, what’s needed now is an integrated strategic response – one that links price to costs and capital, and identifies how to maximise value going forward.

Retail: Time for retailers to ask themselves some searching questions, as the margin vice tightens a few more notches

by Julie Carlyle
Partner, Head of Retail, UK and Ireland

As two props of retailers’ revenues are pulled away…

This year, the EY ITEM Club expects to see real disposable incomes fall by 0.3% and consumer spending growth slow to a four-year low of 1.7% – and then just 0.4% into 2018. For retailers, that’s two vital props of their consumer revenue gone, underlining that what we’re facing is not a mere blip but a longer-term issue.

…UK consumers are being left trailing by “Road Runner”

The fact that the fall in consumers’ spending is lagging behind the decline in their disposable income is down to the twin silver linings of low interest rates and strong personal balance sheets, or what I would sum up as the “Wile E Coyote effect”. You know the scenario: Mr Coyote runs off a cliff and pedals in thin air for a while - until he realises there’s nothing beneath him.

What does this mean for retail businesses?

The perfect storm is brewing and we can hear the rumble of thunder. For the past couple of years I’ve been talking about the “margin vice” affecting retailers, as pressures on margins increase from all sides.

These pressures include the structural squeeze from the margin-dilutive omnichannel model, labour costs, discounting, and more. Add to this the reduction in consumer demand – driven by how much people are able and, more importantly, willing to spend – together with the widely-discussed cost impacts from the falling pound, and the margin becomes even more precarious.

Time to take stock of the new norm…

As this vice tightens, we can be all doom and gloom, or we can look to the future. And the real question about the future is: What is the new norm?

I’ve already said the downturn in consumer spending isn’t a blip. The other pressures are similarly long term. So to be successful in the new world, it follows that retail businesses can no longer simply react to these pressures, but must evolve. In other words, they need to think about the shape of tomorrow’s retail business, and then adapt to fit.

…by asking the following key questions

Retailers already thinking about this are asking themselves many questions. Here are four that are especially relevant amid today’s intensifying pressures:

  • How do you seize your share of a shrinking wallet?

    As consumers, we may expect to have less money in our purses and spend less in the coming months – but this will make us even more discerning about what we buy with our hard-earned £s. And retailers can only snare more of those £s by innovating and providing the right customer experience. So they should look to actively disrupt their own businesses in terms of the customer journey or experience – because those who don’t do this will very quickly run the risk of someone doing exactly that to them. Disrupting your own business is difficult under today’s intense pressure. But the fact is it’s not an option, but a necessity.
  • What type of sales are you looking for?

    Going into 2017 and beyond there’s a much greater focus on profitable sales. The level of promotional intensity across UK retail has been at an all-time high – but from a pricing perspective, retailers are looking firstly to pass on the currency impact (another tough imperative in the current market) and secondly to pull back from discounting to focus on full-price sales. So we may see smaller top lines, but bigger margins!
  • Who do you want to be your customer?

    By looking to engage the demographics (age and income decile) where there is income to spend, those retailers that can “follow the money” may do well, especially in the short term. I’m not advocating that everyone should start chasing the silver pound, but consumers’ behaviours don’t always follow the expected pattern: witness how higher-income consumers now boast about buying bargains from discounters. I would also urge most retailers’ agendas to include targeting tourist and export spend.
  • How productive is your current model?

    To date, retailers have responded to consumers’ rising expectations by running their legacy models in tandem with investing in omnichannel retailing. But to grow profitability and resist the margin vice, they now need to focus on integrating these parallel routes to market into a single business model.

Consumer Products: Time to plan for a spending slowdown - one that’ll hit some consumers harder than others

by Ed Hudson
Executive Director - Consumer Products, UK and Ireland

After a surprisingly strong year for consumer spending…

UK consumers as a whole have had a pretty good year, with their spending buoyed up by a combination of real growth in wages and low interest rates. They’ve also felt the urge to bring forward their spending, seeking to make purchases ahead of the anticipated rebound in inflation due to the recovering oil price and the fall in sterling’s value after the Brexit vote. These powerful positive influences have been further supplemented by rising house and share prices, and a strengthening of many households’ financial position – particularly at higher income levels.

…the environment is about to turn colder…

However, 2017 is looking like a very different proposition, as the tailwinds for consumer spending swing around into headwinds. Inflation is expected to accelerate to 2.8% this year, accompanied by a continuing cash freeze on the benefits that underpin the spending of 11.5m UK households. Add in the possibility of interest rate rises, and it isn’t hard to see why year-on-year consumer spending growth is projected to slow to a four-year low of 1.7%, and why real wage growth will plunge from 1.8% in 2016 to a measly 0.1% in 2017.

…with inflation impacting lower-income consumers more severely

All of this underlines the extent to which inflation is likely to undermine people’s spending power. Petrol prices are already 20% higher than a year ago, imported goods costs have risen 10%, and the cost of goods used by manufacturers is up by 20%. We’re also seeing big rises in domestic energy prices. The two lowest income groups in the economy already spend an average of 24% of their income on food, energy and petrol, meaning they’ll be especially heavily impacted. In contrast, pensioners continue to benefit from the “triple-lock” arrangement, while higher income groups benefit disproportionately from dividend income, rising share price and house price increases.

Three key actions for consumer products businesses

What does this scenario mean for consumer products businesses? They need to take three steps as a matter of urgency.

  • First, review current plans in light of the changed environment. Companies’ planning must reflect the fact that the benign conditions seen in the past six months are no guide to future consumption patterns. Powerful cost pressures have been building up in the supply chain and, while retailers have been trying to hold these back, their capacity to do so is now running out. As prices rise, people will have less disposable income to spend, with negative impacts on companies’ revenues and margins. However, sales of some products – especially essentials – are less affected by price rises than others: think bread versus breakfast cereals. So businesses should examine the variations in price elasticity across their product portfolios, and work out where price increases will have the least dampening effect on sales.
  • Second, analyse the customer base by income level. The past few years have been a period when tax cuts and minimum wage increases have benefited low income groups. That trend is now being reversed, with this segment of the consumer market set to be disproportionately impacted. If a company’s products are targeted at pensioners or better-off households, it may have more time and leeway to react. However, if it’s targeting lower-income consumers it may face double whammy – with the spending downturn hitting it faster and less latitude for price rises.
  • Third, rigorously examine the supply chain cost model. What can be changed to reduce costs and alleviate inflationary pressures? On the cost reduction side of things, perhaps the business can avoid high import prices by sourcing more inputs from UK-based suppliers whose pricing is less affected by the low pound. Or use technology to substitute for labour to reduce operating costs and simplify its operations by re-engineering some processes. On the revenue optimisation side, it may be possible to seek out opportunities for price rises, by assessing the price segmentation of the company’s product categories or targeting export markets to offset likely revenue shortfalls from domestic sales. Paradoxically, an inflationary environment can offer companies the chance to change relative prices as part of an overall portfolio pricing revision. This is much harder to consider in a low inflation scenario.
  • Overall, given the headwinds now confronting consumers, it would be an illusion to believe that the same people will keep on spending at the same level as they have in the recent past. It’s time for consumer products businesses to adapt to the new reality.

 

EY have been sole sponsors of the ITEM Club for 25 years. It is the only non-governmental forecasting group to use HM Treasury's model of the UK economy. Our reports provide a detailed economic analysis and forecast of economic activity for the period ahead. They are independent of any political, economic or business bias.

Contact

EY - Mark Gregory

Mark Gregory

EY Chief Economist

EY - Julie Carlyle

Julie Carlyle

Partner and Head of Retail

 
EY - Ed Hudson

Ed Hudson

Executive Director